Tax treatment for trusts

The Tax Rates for Trusts

Special trusts are taxed at the rates applicable to individuals. A special trust is one created solely for the benefit of a person affected by a mental illness or serious physical disability which prevents that person from earning sufficient income to maintain himself, or a testamentary trust established solely for the benefit of minor children who are related to the deceased. Where the person for whose benefit the trust was established dies prior to or on the last day of the year of assessment or the youngest beneficiary, in the case of a testamentary trust, turns 18 (2013: 21) years of age prior to or on the last day of the year of assessment, the trust will no longer be regarded as a special trust. All other trusts are taxed at the rate of 40%.

A loss incurred by a trust cannot be distributed to beneficiaries. The loss is retained in the trust and carried forward to the next year as an assessed loss.

Special Trusts

Trusts are often used by estate planners in planning for administrative and tax efficiency after the planner’s demise – and correctly so. However, a much overlooked vehicle is the “special trust”, which has all of the advantages of a ‘regular’ trust but with significant added tax benefits.

A “special trust” is a regular trust for all purposes other than the way it is taxed. The term ‘special trust’ is defined in section 1 of the Income Tax Act and are a vehicle to house the assets of a person with a serious mental or physical disability. But it is less widely known that there is another part to the definition of a “special trust”- namely a trust set up in terms of the will of a deceased person, solely for the benefit of ‘relatives’, the youngest of whom is under the age of 21 on the last day of February of the relevant tax year. The definition of ‘relative’ in the Income Tax Act includes anyone related to the person or his or her spouse to the third degree of consanguinity i.e. it includes great-grandchildren and nephews and nieces.

A special trust enjoys all of the benefits with regard to separation of assets and ease of administration that are afforded a ‘regular’ trust, however, instead of being taxed at the flat rate of 40 % on its taxable income a special trust is taxed on the same favourable sliding scale that applies to the taxation of individuals. It also enjoys the advantageous treatment afforded to individuals with regard to the rate of taxation on capital gains, which are taxed at a maximum effective rate of 10 % as opposed to 20 % in the case of a ‘regular’ trust.

It is implied by the definition of “special trust” that such a trust could only enjoy the added tax benefits until the youngest beneficiary turns 21. Thereafter the trust will be taxed on the same basis as a regular trust. Nevertheless, the tax benefits that could accrue during the period in which the trust is taxed as a ‘special trust’ can be enormous.

Take for instance the situation where a father, in his will, directs that on his death a trust be established for the benefit of (only) his children. He dies when the youngest of the children is four years of age. Such a trust would qualify as a “special trust” in terms of the definition above. He bequeaths R10m in cash to the trust. The trust uses the R10m to purchase a portfolio of shares. If the shares yield an 8% compound capital growth rate per annum, when the youngest child is 20 years old the portfolio will be worth R34.26m. If the trust were to sell the shares in that year and retain the gains, the savings in capital gains tax would amount to more than R2.42m, when compared to the tax that would have been payable had the trust been a regular trust. This is besides the savings in income tax over the period on dividends from foreign shares in the portfolio.

After the trust no longer qualifies to be taxed as a “special trust”, it does not have to be terminated – it can continue in existence as a ‘regular’ trust, without the special tax treatment outlined above. My advice is that serious consideration should be given to the use of a ‘special trust’ when doing any estate planning exercise. As the majority of laypersons are not versed in issues relating to the taxation of trusts, this is especially the case for those in the financial planning arena, where considering the appropriateness of a ‘special trust’ should be standard item on the due diligence checklist.